The Non-Registered Investment: RRSP and TFSA's not so tax friendly cousin

Investments held inside a non-registered account are taxed in the year it has earned, and the amount and type of taxes will depend on if the investment generated interest income, dividend income, or capital gains. The ever so popular RRSP is more tax efficient with available tax deferral on all gains inside an RRSP as well as reducing taxable income with RRSP contributions. Withdrawing income from an RRSP will be fully taxed based on your tax rate at the time of withdrawal. The not-so-new-anymore TFSA (Tax Free Savings Accounts) allows tax free growth inside the account as well as tax free withdrawals, but with no option to reduce taxable income with contributions.

Typically, an individual who has maxed out RRSP and TFSA contributions will then look at their options within a non-registered account. It should be noted, although some people will accumulate RRSP contribution room year to year it may not make sense to make contributions to your RRSP depending on your tax bracket, as well as other potential complex financial situations that this particular blog won't dive into.

If you're considering a non-registered investment, first and foremost make sure you've fully

taken advantage of the benefits of your TFSA. Once that is done, let's understand the taxation of these non-reg accounts. Interest income will be taxed the highest in non-registered accounts at your full marginal tax rate. Investments in bonds and GIC's are products that earn interest income. Canadian dividends are taxed more favourably than interest income as they are taxed based on a grossed up amount and subject to a dividend tax credit. The most favourable investment when looking at a purely tax-efficient standpoint would be investments that earn capital gains. Capital gains are only taxed on 50% of the realized gain, so if you had a $10,000 capital gain inside your investments then only $5000 would be taxable.

When selling non-registered investments you will have to pay tax on any gains not yet taxed, but you also have the option of selling when your investments are realizing a loss to take advantage of offsetting other gains. Looking strictly at the taxes when buying or selling should only be part of your decision here, as you should be considering other details about your financial plan before doing so.

It's simple then, let's just buy investments that generate capital gains to be the most tax efficient with our non-registered investments. Right?

Well, not exactly. You should be making investment decisions considering many relevant factors which would include tax efficiency. Risk tolerance, investment objective, asset allocation, and time horizon should also be taken into consideration and included when deciding on your investments. Some investors do not want to take the investment risk of equities or stocks that earn capital gains and really shouldn't be forced to if it doesn't fall into their risk tolerance, regardless of the taxation.

There is an option to earn interest income inside a non-registered investment and be taxed more favorably via a corporate class mutual fund. A regular mutual fund has a trust structure that sends out T3 tax slips that report any taxable income the fund earns each year. Through the corporate class structure though, the corporation is the tax entity and has the ability to defer capital gains until a sale, as well as having the ability to offset interest and dividend income through the expenses of the aggregate class structure. In essence, swapping interest income for capital gains. In some cases though, some investors may prefer receiving year end tax slips and pay tax on the gains as they accrue.

To sum up, non-registered investments actually have tax efficient options available to Canadian investors, but do not let taxation be the only factor when deciding on your options. An experienced tax professional or financial planner can help.

Happy Saving!

-Marty Metz, CFP, CLU